Small Business Promissory Notes: What You Need to Know

Learn how a promissory note can be used to structure the repayment of a business loan.

When you borrow money, a promissory note lays forth the terms of repayment. There are various options for structuring repayment, each with its own set of benefits and drawbacks. It pays to grasp the ins and outs of each sort of repayment plan so you can select the best option for your company

When Should I Use a Promissory Note?

You will be required to sign a promissory note if you borrow money for your business from a commercial lender. When borrowing money from a friend or relative, you should also utilize a promissory note. It doesn't hurt to document the loan, and it can help avoid misconceptions about whether the money is a loan or a gift, when it must be repaid, and how much interest is due. It also serves as a record of the loan's terms in case the IRS conducts a business audit.

Types of Repayment Schedules

Promissory note forms are provided by banks. You'll need to utilize a promissory note from form books or software if you borrow from a friend or relative. Promissory notes have a wide range of legal and practical terms, but the most essential thing is to choose a repayment plan that works for you. Four distinct approaches are presented below.

1. Amortized Payments

You pay the same amount each month (or year) for a certain period of months using amortized payments (or years). The interest portion of each payment is deducted, and the remainder is applied to the principle. The loan and interest are totally paid when you make the final payment. This form of loan is fully amortized over the amount of time that you make payments, according to legal and accounting terms. (If you've ever paid off a vehicle loan or a mortgage, you've definitely dealt with an amortized repayment schedule.)

You may figure out the amount of the installments using software like Intuit's Quicken or Quickbooks, or an online calculator, after you know the loan parameters (the amount you want to borrow, the interest rate, and the time period over which you'll make payments). You can also use a printed amortization schedule, which can be found in commercial lenders' offices, business publishers' offices, and local libraries.

2. Equal Monthly Payments and a Final Balloon Payment

For a relatively short amount of time, you must make equal monthly principal and interest payments under this repayment schedule. After you've made your final installment payment, you'll have to pay the remaining principal and interest in one lump sum, known as a balloon payment.

Because the monthly payments are reduced over the duration of the loan, you will have more money available for other purposes. Of course, don't forget about the enormous balloon payment lurking around the corner when you're thinking about those pleasant modest payments.

Balloon payments can come with additional hazards. You're gambling that interest rates will stay the same or go lower over the life of the loan if you plan to take out a new loan when it's time to pay the balloon payment. And if you're buying an asset (like a building) with the intention of selling it soon to pay off the loan before the balloon payment is due, you're betting that the asset won't depreciate.

3. Interest-Only Payments and a Final Balloon Payment

An interest-only loan requires you to repay the lender by making monthly interest-only payments over a period of months or years. The principal remains unchanged. You must make a balloon payment to settle the principle and any outstanding interest at the conclusion of the loan period.

The cheap payments are an evident benefit of this arrangement. You can also frequently prepay principle if you find yourself in the fortunate position of having additional income. However, because you're borrowing the principal for a longer period of time, you'll pay more interest in the long run. For example, if you make equal amortized payments on a $20,000 loan over four years, you will pay about $3,000 less than if you make interest-only payments plus a final balloon payment.

4. Single Payment of Principal and Interest

Some loans, particularly those from friends and family, may not need regular interest and/or principal payments. Rather, you pay off the debt in full at a predetermined future date. This payment covers the entire principal amount as well as any interest that has accrued. This type of loan is best for a short-term loan or if the lender isn't concerned about timely repayment. A commercial lender is unlikely to provide you a deal like this.

Read the Fine Print

Whatever method you choose for repayment, make sure you read your promissory note and any other loan agreements thoroughly. Commercial lenders' promissory notes, in particular, frequently contain a lot of legalese and terrifying concessions of legal rights.

Check to see whether you may prepay the loan without incurring a penalty — certain states enable a lender to charge you a fee for prepaying the loan (which is essentially designed to reimburse the lender for the loss of future interest).

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